Investors contemplating an arrangement which is being marketed as a ‘mortgage management’ plan should be wary. Under this scheme, split loan arrangements – that is, the combination of an investment loan, a home loan and a credit facility – are being promoted as providing tax-effective financing and therefore have attracted the attention of the Tax Office.
The schemes generally involve a person taking out one loan for their ‘principal place of residence’ (the family home) and an additional loan for an investment property. The investor then establishes a line of credit facility. The Tax Office says taxpayers often partake in split loan arrangements to pay off their home mortgage sooner.
In response to a surge in such schemes, the Tax Office has issued a recent tax determination – known as TD2012/1 – to alert taxpayers to the fact that the general anti-avoidance provisions may be applied to deny interest deductions.
How the ‘mortgage management’ scheme works
Under the mortgage management plan arrangement, an individual owns at least two properties:
• their residence
• an investment property.
The individual has:
• an outstanding loan used to acquire their residence (home loan)
• an outstanding loan used to acquire the investment property (investment loan), and
• a line of credit with an approved limit (line of credit).
The home loan, investment loan and the line of credit are each secured against the individual’s residence and/or the investment property. The line of credit is drawn down to fund the interest payments on the investment loan as they fall due.
Typically, the taxpayer’s cash inflows (including that which the taxpayer might reasonably be expected to use to pay the interest on the investment loan) are deposited into their home loan, which reduces the non-deductible interest otherwise payable on the home loan.
The following diagram illustrates how the scheme works.
All three loan products are typically provided by a single lender. The interest rates on the home loan and the investment loan are also generally the same whereas the interest rate on the line of credit is marginally higher.
The investment loan is typically an interest-only loan for a specified period with principal and interest repayments required thereafter while the line of credit has no minimum monthly repayment obligations provided the balance remains below the approved limits.
If the line of credit reaches its approved limit before the home loan has been repaid, the individual may apply to increase the limit on the line of credit in conjunction with a corresponding decrease in the available ‘redraw’ amount in the home loan.
Warning: The Tax Office warns that split loan schemes are likely to be considered a tax avoidance scheme as the dominant purpose of the arrangement is to claim tax deductions that would not otherwise be available.
Tax Office’s Approach
The determination highlights the Commissioner of Taxation’s power to cancel a tax benefit, or part of a tax benefit, that has been obtained in connection with a scheme to which the general anti-avoidance provisions apply. The Commissioner concludes that this is the likely outcome for participants in the mortgage management plan arrangement. However, this must ultimately be decided on the basis of the facts in each case.
In the Tax Office’s view, an individual’s purpose of ‘paying their home loan off sooner’ or ‘owning their home sooner’ is not in itself an adequate defence against the application of the general anti-avoidance provisions.
The Commissioner identifies the following factors:
• The manner in which the scheme is entered into or carried out is generally explicable only by the tax consequences.
• The interest rate on the line of credit is typically higher than the interest rate payable on the home loan.
• Apart from the alleged availability of additional tax deductions, the taxpayer’s financial position under the scheme is generally no better (and possibly worse) than if they had not engaged in the split loan scheme.
• A key feature of the scheme is the use of the line of credit to pay the interest on the investment loan. This results in most of the interest on the investment loan, in effect, being deferred. The deferral has the economic effect of allowing the taxpayer to repay the home loan at a faster rate than what would otherwise be possible: the taxpayer is able to pay an amount equivalent to the deferred investment loan interest on the home loan.
• A scheme can only have a limited lifespan. The scheme will only last for the period during which the taxpayer has non-deductible interest expenses (home loan interest) and once that debt is repaid, the taxpayer is likely to revert to making the payments on their investment loan out of their cash flow instead of using a line of credit.
• If the taxpayer’s residence is used as security for either the investment loan or the line of credit, the taxpayer will not actually own an unencumbered home any faster than if they had not engaged in a split loan scheme.
How to protect yourself from tax avoidance schemes
Anyone involved in a split loan scheme who voluntarily tells the Tax Office about their involvement in such a scheme, may be eligible for a reduction in any penalties they may face.
Before committing to an investment arrangement, ensure you understand the ins and outs of the arrangement and are certain that the promised tax benefits are legally available. Check with our office on the steps that can be taken to avoid involvement in what may be considered a tax avoidance scheme, such as:
Step 1: Conduct research on the creator of the investment arrangement: Investigate the origins of the party that has created the investment arrangement offered as this can be an indication as to whether the investment arrangement is lawful or not.
Step 2: Obtain a product disclosure statement (PDS) from the arrangement creator/promoter:
If the arrangement constitutes a public offering, you must be given either a PDS or a prospectus when an arrangement is recommended or offered.
A PDS must set out important information about an investment arrangement, including details of fees and commissions, outlining the benefits and risks of the investment and other information to help you and your adviser make an informed decision.
Step 3: Obtain a product ruling: If uncertain about the tax-related consequences of the arrangement, there may be a product ruling that has been issued in regards to the arrangement. It is crucial that the arrangement is implemented exactly as it has been outlined in the ruling because a product ruling only provides you with legally binding assurance that the tax deductions set out in the ruling are available when the scheme is carried out as described.
Before considering a tax-effective investment, run through the quick checklist which follows: